Wednesday, July 29, 2009

The Importance of Jurisdiction

By Jon Matonis

Today's digital gold currency issuers are the new Lydians. During the 6th century BC, the Aegean civilization of Lydia sparked a vibrant commercial revolution through the invention of coinage. The first gold coins were struck by King Alyattes and then by his son King Croesus of Lydia sometime around 600-560 BC, and the coins served as a primary currency which significantly increased trade and commerce in the region. Although the monarchy usurped the control of money and established the prerogative of issuance, it was the Lydian people and merchants that were not only responsible for the introduction of coinage but also the early formulation of a gold standard of value through private weights and measures.

It is not a stretch to imagine that the most successful non-political digital currencies also will have some type of precious metals backing. In a digital world where trust is craved, the currency issuers with the most reliable form of "auditable" backing will have a distinct advantage. However, the legal and territorial jurisdictions of the company's administrative offices, host computer servers, and physical bullion storage ultimately may play an even more important role.

To understand why this is true is to appreciate the nature of the attractiveness of digital currencies to the average account holder. It is much more than a desire to protect value that would otherwise be held in a depreciating government currency like the US Dollar or Euro, although that is important too. Not surprisingly, it extends equally into areas such as financial privacy, political stability, and protection from confiscation.

Economically and philosophically, the aim of pure digital cash is to replicate the transactional features of a $100 bill or a 500-euro note, which primarily means that it should be anonymous and untraceable. So, why do so many right-minded people object to these features in the online world? I am sure that they would not advocate mandatory photographs and audit trails for users of $100 bills. This is an extremely vital distinction because various commerce laws are being used by governments to violently suppress the online issuers of anything that is anonymous and untraceable. It would not be acceptable to eradicate $100 bills, or even $50s or $20s, so what becomes the difference in the online world?

The major difference is that online digital cash opens up a host of previously unavailable transaction types that will not require physical presence for the exchange of paper cash. It is this potential for customer-not-present transactions which strikes fear with the authorities, because of the "dire" consequences for tax evasion and money laundering, not to mention the darker side of blackmail, extortion, and ransom. Suitcases of cash will no longer be needed at predetermined drop-off points. There won't even be any drop-off points and therefore the frequency and value of all types of untraceable customer-not-present transactions will increase dramatically in an unregulated, "parallel" economy. The morally-positive transactions, such as political prisoner border crossings and tax-free exchanges, will coexist with the morally-negative transactions just as they do today. A parallel economy in the digital sphere has enormous implications for the world's taxation authorities.

We should not take for granted the privacy rights contained within a $100 bill -- they are a wonderful thing for freedom. Jurisdictions that embrace and permit these already-existing privacy features will attract digital currency issuers and therefore thrive in the online financial world. As to the associated morality of various transactions, it is no more the responsibility of the digital currency issuer than it is currently the responsibility of the manufacturer of $100 bills and 500-euro notes. Those types of arguments around judging and enforcing the morality of certain transactions only serve to muddle the true free-market argument for digital currency.

All of these political and moral sensitivities taken together demonstrate why jurisdiction is so vitally important to the emergence and survival of non-political digital currency. Authoritative forces are lined up against its emergence from the beginning, and there will be an ongoing high-stakes battle for survival, as recently observed in the U.S. federal case against e-gold being prosecuted as an unlicensed money transmission service. International governments and police forces will all cooperate with each other in a desperate attempt to retain monetary supremacy, so old laws will be tweaked to make them applicable, and new direct legislation will be enacted to fill any voids. This scenario will play out across the globe where the larger and stronger nations exert diplomatic, economic, and possibly military pressures on the non-compliant nations.

Not surprisingly, even the U.S. government recognizes that restricting digital currencies on the Internet will require unprecedented international coordination. As stated in a 2008 U.S. Department of Justice study on Money Laundering in Digital Currencies:
"U.S. regulatory action alone will not be sufficient to suppress the money laundering threat posed by digital currencies. Even if clear and consistent regulatory measures are imposed, digital currency services established in foreign and offshore jurisdictions—which are not subject to the Bank Secrecy Act (BSA)—can be used to conduct transactions in the United States. Limited international oversight of this expanding financial service is possible through a recommendation of the Financial Action Task Force on Money Laundering (FATF)."
To be sure, jurisdictional risk is but one of many risks in the digital currency business, with the others being technological risk, encryption/security risk, audit risk, fraud risk, and business default risk. But it is jurisdictional risk that has the most profound impact on long-term viability because it is the least correctable once launched. In addressing jurisdictional risk, the digital currency issuer must consider multiple jurisdictions for each of the functional areas and perhaps even two or more jurisdictions within each functional area for redundancy. For example, both a Central American country and an Asian country for location of hosting servers would provide load-balancing and continued reliability in the event of a changing political climate against anonymous digital cash server farms in one country.

Administrative offices may be part of a legal entity in a faraway, remote jurisdiction and have physical staff and buildings in a large, populated city, thereby placing them in a different territorial jurisdiction. Both jurisdictions are important to consider because both will have differing legal statutes related to the issuance and management of anonymous, untraceable digital currency. It is not the objective of this analysis to promote one jurisdiction over another, primarily because ideal jurisdictions will be in a constant state of change due to their political nature. However, it is possible to look at some selected jurisdictions of existing digital currency issuers.

One such issuer established a Panamanian international business corporation (IBC) as a holding company with a subsidiary Haitian company as the administrative general contractor and a subsidiary Burmese corporation as the payment system operator. In addition to distributing legal jurisdiction risk, this structure served to insulate the administrator from the business risks associated with default of the operator. Another issuer established the administrative body in the Seychelles with operations and customer support outsourced to a Malaysian company.

For administrative legal jurisdiction, Panama, Belize, Costa Rica, Nevis, and Seychelles have been popular because of their banking secrecy heritage, minimal tax structure, and/or their distance from the reach of the U.S. legal system. They are decidedly not one of the 32 member countries of the FATF international body. Establishing in non-FATF member jurisdictions can be a double-edged sword for the digital currency customers because untrustworthy issuers may be insulated from judgments related to fraud, so issuer reputation will be of paramount importance to overcome that concern.

In the case of territorial jurisdiction, it is not always clear where issuers maintain their physical presence because they have mostly been small, movable organizations capable of operating virtually. Diligence should be observed if loosely guiding or operating a digital gold currency entity from a shareholder's home country, such as the United States, because territorial jurisdiction will prevail regardless of where the corporate entity was formed. Since legal and territorial jurisdictions are different from an enforcement perspective, the issuer ideally should establish separate legal entities for each location.

For the location of international bullion storage, issuers have selected domiciles that have a longstanding reputation of storing precious metals, such as Zurich, London, and Vienna. Now, Dubai is an up-and-coming storage center for precious metals in that it is already one of the largest centers for trading gold managing one-fifth of global annual gold production. Geographic diversification in vault selection makes sense in a world where established financial centers have experienced increased pressure to eliminate financial privacy, and the threat of asset confiscation persists.

The complete jurisdictional framework for digital currency issuers is a multinational structure of various corporate entities that have either subsidiary relationships within the framework or pure outsourcing arrangements to separately-owned entities. They will function best when they have considerations for distributed risk and redundancy built in and when they utilize best-of-breed locations for the particular functional areas.

This article was also published in Digital Gold Currency Magazine (August 2009).

For further reading:
"Fab Four: The 4 Best Asset Havens in the World", The Sovereign Society, June 2008

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